Fed’s Dudley says pace of rate hikes to be ‘slow’

William C. Dudley, president and chief executive officer of the Federal Reserve Bank of New York.

WASHINGTON (MarketWatch) — The Federal Reserve will take its time lifting interest rates, a key official said Tuesday in a speech devoted as much to answering how as answering why.

William Dudley, the president of the New York Fed, tackled a number of key topics in a speech, including the stagnant housing market, the slack in the labor market, when the Fed may hike interest rates and how high.

Dudley, who gets a vote at every Federal Open Market Committee meeting and is vice chairman of the interest-rate setting committee, told the New York Association for Business Economics that there will be “a considerable period of time” between the end of its asset purchases (in the fall, he says) and the first rate hike.

Noting both market and Fed expectations that the first hike will come some time near the middle of 2015, Dudley said, “if the economy is stronger than expected, causing the excess slack in the labor market to be absorbed sooner and inflation to rise more quickly than forecasted, then lift-off is likely to be pulled forward in time. If, instead, economic growth disappoints, inflation stays unusually low and the labor market continues to exhibit evidence of considerable excess slack, then lift-off will likely be pushed back in time.”

In a separate speech, Philadelphia Fed President Charles Plosser said the Fed may need to act sooner rather than later should the economy accelerate. But Dudley is seen as a more important voice on the FOMC, so his comments may have more of a bearing over Fed policy.

Dudley meanwhile said the trajectory of hikes will “probably be relatively slow” — but that depends both on how the economy performs and how financial conditions respond to tightening.

“If the response of financial conditions to tightening is very mild—say similar to how the bond and equity markets have responded to the tapering of asset purchases since last December—this might encourage a somewhat faster pace. In contrast, if bond yields were to move sharply higher, as was the case last spring, then a more cautious approach might be warranted,” Dudley said.

He expects the level of rates over the longer-term to be “well below” the historical average of 4.25%. Dudley gives three reasons: the Great Recession has scarred households and businesses into greater precautionary savings and less investment for a long time; the slower growth of the labor force due to the aging of the population and moderate productivity growth; and higher bank capital requirements.

Dudley touched on two hot-button issues on the economy: for one, he dismisses the idea that the labor market is tighter than the headline unemployment rate due to the level of longer-term jobless.

“I suspect that a much greater proportion of those who are currently long-term unemployed have simply been very unlucky compared to historical averages. This blunts somewhat the distinction between being short- versus long-term unemployed,” he says.

Also, on the housing market, he said it’s been weaker than anticipated due to still-tight mortgage credit, higher student-loan burdens, the difficulty in shifting resources back into making new homes, and the fact that in some markets the prices of homes still appear to be below the cost of building a new one.

As for the over $4 trillion worth of bonds on its balance sheet, Dudley expects them to be reduced via “automatic pilot” — in other words, as Treasury securities mature and mortgages are repaid. In a change, he said outright sales of MBS are no longer contemplated, and that the Fed shouldn’t stop reinvesting payments of principal before rates are lifted. In fact, he suggested the Fed may want to lift interest rates before stopping the reinvestment.

“Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer,” Dudley said.

He said the ability to pay interest on excess reserves, and so-called reverse repos could help manage money-market rates. A reverse repo is when the Fed accepts cash from counterparties such as banks and money-market funds on an overnight basis in return for a security.

“Although the testing process is still ongoing, early results suggest that the overnight RRP facility will set a floor under money market rates,” Dudley said.

He said there are questions about how much volume the facility should have and its impact on financial stability. He wondered if there were a financial crisis, if there would be runs out of more risky assets into such a facility. But he said there could be “circuit breakers” that would cap overall usage.

Dudley seemed to pour cold water on the idea the Fed could offer banks term deposit accounts for longer terms than overnight, saying it might be necessary to drain $3 trillion worth of reserves.

“This could be done of course with effort, but is the effort worth it?” Dudley asked. He also said the Fed would have to pay up to induce banks to hold term deposit accounts.

Economists said the speech indicates the exit debate is taking place. “We see Dudley as having an influential role in any reset of the Fed’s exit principles and his comments suggest that a further rethink of the exit principles is under way,” said Michael Gaspen of Barclays Capital.

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